VAN vs TIR: Which is better for your investment decisions?

When evaluating an investment project, you probably ask yourself: what will be my actual profit? This is where two fundamental metrics come into play: Net Present Value (NPV) and Internal Rate of Return (IRR). Although both measure profitability, they do so in different ways. It’s common for these tools to yield contradictory results: a project may look attractive based on NPV but less appealing based on IRR. Understanding what NPV and IRR are, as well as their differences, is essential for making smarter financial decisions.

Key Differences Between NPV and IRR

While many investors use NPV and IRR interchangeably, the reality is that they answer different questions:

NPV (Net Present Value): Answers the question, how much money will I earn in terms of present value?

IRR (Internal Rate of Return): Answers the question, what is my annual profitability percentage?

The fundamental difference lies in that NPV provides an absolute dollar value, while IRR gives a percentage. When cash flows are uniform and the project is simple, both metrics coincide. But in complex investments or with irregular cash flow patterns, they can contradict each other.

What is Net Present Value (NPV)?

Net Present Value is the value of all future cash flows you will receive, expressed in today’s money. Its logic is simple: money today is worth more than money in the future due to inflation and opportunity cost.

To calculate it, you take the expected income for each year, discount it at a specified interest rate, and subtract the initial investment. The result tells you whether the investment will generate net gains or losses.

A positive NPV means you will recover your investment and make additional profit. A negative NPV indicates a loss.

NPV Calculation

The formula is:

NPV = (Cash Flow Year 1 / ((1 + Discount Rate)¹) + )Cash Flow Year 2 / ((1 + Discount Rate)²( + … - Initial Investment

Practical example with positive NPV:

Invest $10,000 in a project that will generate $4,000 annually for 5 years, with a discount rate of 10%:

• Year 1: $4,000 / 1.10 = $3,636.36
• Year 2: $4,000 / 1.21 = $3,305.79
• Year 3: $4,000 / 1.331 = $3,005.26
• Year 4: $4,000 / 1.464 = $2,732.06
• Year 5: $4,000 / 1.610 = $2,483.02

NPV = $15,162.49 - $10,000 = $5,162.49

Since it’s positive, the project is viable.

Example with negative NPV:

Invest $5,000 in a deposit certificate that will pay $6,000 in 3 years, with an 8% rate:

PV = $6,000 / )(1.08)³) = $4,774.84

NPV = $4,774.84 - $5,000 = -$225.16

Negative NPV indicates it’s not profitable.

What is the Internal Rate of Return (IRR)?

IRR is the annual rate of return you will get from your investment. It is the discount rate that makes the NPV exactly zero. In other words, it’s the breakeven point where gains equal the investment.

IRR is expressed as a percentage and allows you to compare the profitability of different projects regardless of their size. If IRR exceeds the market benchmark (for example, the yield on a Treasury bond), then the project is considered profitable.

Why can NPV and IRR contradict each other?

Imagine comparing two projects:

• Project A: NPV = $50,000 but IRR = 12%
• Project B: NPV = $30,000 but IRR = 25%

Which do you choose? The answer depends on your investor profile and objectives.

Discrepancies mainly occur due to:

1. Project scale: A large project may have a higher NPV but a lower IRR than a smaller one.
2. Timing of cash flows: If income arrives very late, IRR can be low even if NPV is attractive.
3. Discount rate used: A very high rate reduces NPV but does not affect IRR in the same way.

When facing contradictions, it’s recommended to review your assumptions about discount rates and cash flow projections carefully. Sometimes, adjusting the discount rate better reflects the project’s actual risk.

Limitations of NPV

NPV has significant weaknesses:

• Depends on subjective estimates: The discount rate is a number you choose. Different investors may use different rates and reach different conclusions.
• Ignores risk: Assumes your projections are 100% accurate, ignoring real market volatility.
• Lacks flexibility: Presumes you will make all decisions at the start of the project.
• Not ideal for comparing projects of different sizes: A (million project may have a higher NPV than one of )thousand but be less efficient.
• Does not account for inflation: Not always properly adjusting for future inflation impacts on cash flows.

Despite these limitations, NPV remains one of the most used tools because it’s relatively easy to understand and provides a concrete monetary value.

Limitations of IRR

IRR also has pitfalls:

• Multiple solutions: For investments with non-conventional cash flows $1 changes between positive and negative$100 , multiple IRRs can exist, confusing evaluation.
• Assumes reinvestment at IRR: Presumes you will reinvest positive cash flows at the same IRR, which is often unrealistic.
• Inappropriate for irregular cash flows: If you have significant expenses in later years, IRR can be misleading.
• Depends on the discount rate: Although IRR is calculated independently, the choice of rate for comparison influences your decision.

IRR is especially useful for projects with uniform and predictable cash flows but fails in complex scenarios.

NPV and IRR: Use Together or Separately?

The answer is: together.

NPV tells you how much absolute money you will earn. IRR indicates the percentage profitability. Used jointly, they provide a complete picture:

• A project with high NPV but low IRR might be good if you have abundant capital.
• A project with high IRR but low NPV could be ideal if you seek efficiency with limited capital.

Other indicators that complement your analysis:

• ROI (Return on Investment): Measures the net profit percentage.
• Payback Period: How long it takes to recover your initial investment.
• Profitability Index (PI): Compares the present value of inflows to initial investment.
• Weighted Average Cost of Capital (WACC): The minimum return rate your company demands.

Frequently Asked Questions

How do I choose the correct discount rate?

Consider three factors: opportunity cost (what you could earn in a similar investment), the risk-free rate (Treasury bonds) as a starting point, and sector comparative analysis. Your experience and intuition also matter.

What if NPV is positive but IRR is very low?

It means you will recover your money but with modest profitability. Check if there’s a better investment alternative before deciding.

Does the discount rate affect both metrics?

Directly affects NPV: higher rates reduce NPV. IRR is calculated independently, but the rate you choose for comparison influences your final decision.

Should I rely solely on NPV and IRR?

No. Both depend on future projections and carry some uncertainty. Complement with risk analysis, diversification, personal objectives, and overall financial situation.

Conclusion

The (NPV) and (IRR) are complementary, not competing. Each answers a different question about your investment. NPV measures absolute gains, while IRR measures percentage profitability.

When both tools align, your decision is clear. When they diverge, review your assumptions and risk considerations carefully. Remember, both metrics are based on future estimates, so they are not guaranteed predictions but tools to reduce uncertainty and make more informed investment decisions.